Clear Eyed Capitalist

Archive for the ‘Nonprofit Practice’ Category

A frequent question in the arena of social enterprise is what legal structure to be: for-profit, non-profit or hybrid? The question is sufficiently confusing that Criterion Ventures has been successfully touring the country for over a year hosting day-long “Structure Lab”s to give folks some tools sort out the issues. I took one and found it practical and helpful. One of the issues to think about is fundraising – where will your funding come from and what are its constraints? That may put constraints on your structure. While folks in your lab may be helpful beyond that, note: they don’t give specific legal advice at the workshop. So let’s walk that through informally now: earned revenue can go either way; any structure can take debt; equity returns require a for-profit. A tax-writeoff can be interesting – if there’s a non-profit intermediary willing to take expenditure responsibility (and your organization legitimately accomplishes a 501c3 compatible purpose) it could be possible to be a for-profit and get support from someone who wants to make a donation, definitely if that donation is to a community development loan fund who turns around and loans to the for-profit.

Perhaps you see how the hybrid model can get squishy, particularly when there’s a non-profit raising funds and contracting with a for-profit. A dear reader got me started on this post (Thanks Tony!) with an article from today’s NYT “Hybrid Model for Nonprofits Hits Snags”. That article talks about how GlobalGiving, a non-profit, had a for-profit subsidiary called ManyFutures Inc, that was trying to provide a technology platform to GlobalGiving and commercialize it. In this instance, the founders (who founded both organizations) lost money on the for-profit. Since they didn’t benefit at all it’s difficult to suggest they benefited unfairly. Still, close relationships raise the spectre of private inurement: “providing excessive benefit to a person who is close to or has a controlling interest in a nonprofit — though tax law says nothing about how much is too much”, according to the NYT. Periodically the media has raised the issue of “too much” – Minnesota Public Radio came under fire in the early ’90s because of high salaries at its for-profit subsidiary which handled the retail side of public radio. Dan Palotta, created the for-profit Palotta TeamWorks, and raised millions for charity by organizing sporting events (and earning revenue for doing so) until he came under fire for personally profiting too much. He’s written a book about how he believes the charitable model is broken, called “Uncharitable”.

So in the boom time, we got to see what happens when hybrids do well – we raise the issue of “how well is too well?” Now in the bust the NYT questions if hybrids are particularly vulnerable to failure. Are they? Are social mission enterprises in general? Getting away from hybrids, why choose for-profit vs non-profit for an earned revenue social mission? The current wisdom seems to be that it’s easier to raise money for a for-profit than a non-profit, especially when you’re looking at big dollars. People will commit more when they’re self-interested. Kevin Doyle Jones (also quoted in the NYT article) used to talk about “two-pocket thinking” -the investment pocket and the charitable pocket. In my experience consistently the investment pocket is bigger. The current economy raises another possible factor…

I’m feeling very aware of how many for-profits (not necessarily mission-related) I’m invested in are themselves largely charitable enterprises right now- many companies are losing money in this economy and we investors are ponying up in the hope of making good on our existing investments. Losing money and struggling to find traction for the business model like Many Futures, Inc doesn’t seem unique to hybrids or social enterprises to me. Maybe the biggest difference between these social enterprise models and for-profits is that when we donate to a non-profit, or even invest but with low return expectations (and therefore somewhat charitably) in a for-profit, we “write it off” both mentally and literally at the time of the investment, so it doesn’t have the lure of… I’ll call it “Salvag-ation”. In the for-profit investment where we hoped (or planned) to reap a reward, our difficulty in recognizing sunk costs and our hope of an eventual recovery perhaps keeps prior investors coming back to prop up a flagging enterprise through a couple extra difficult years. Perhaps that commitment, intentional or not, is what gives for-profits an edge in building a sustainable revenue stream. In fact, that reminds me of a quote I first heard during the Long Term Capital Management days though I see now it’s attributed to J. Paul Getty: “If you owe the bank $100 that’s your problem, if you owe the bank $100 million, that’s the bank’s problem”. In a for-profit, financial self-interest binds us together.

What’s the difference between an investment and a grant? The obvious difference is that one is to make money and the other is to make change. What happens in social impact investing where the goal is to do both? That question has been on my mind lately as I look at a couple potential social impact investments.

The current investment I’m looking at is a non-profit aiming to spin out a commercial enterprise to run a potentially self-sustaining (and even lucrative) social business. The trouble is that the project is so early stage at this point that it’s questionable whether it’s an investable enterprise or should be considered a research project – the kind that if they were coming from the for-profit world we’d all be trying to get grant funded. However coming from the non-profit world there seems to be a bit of a pinnochial urge to be a real boy and they’re determined to incorporate. As someone who could write a grant or could make an investment I’ve been pondering which I’d prefer they be at this stage. There’s a level at which I myself want to be a real investor and that makes it far more comfortable to write a grant because then I don’t have to measure my success based on the return. Research projects can be successful by proving their hypothesis unfeasible but that’s less palatable in early stage companies.

As a social impact investor I’ve gotten comfortable in the space referred to as “a concessionary return” – but for me that means lending at 2.5% to CDFIs. I’ve gotten some looks at anticipated negative returns – I know of a fund that lends at 0% and covers the cost of operations out of the fund so inevitably it consumes a low but steady % of the capital on an annual basis. I haven’t “invested” in that fund and my understanding is the original investors established it with a grant, wisely enough. That reinforces my distinction that for an investment there should be the expectation, at least the opportunity, of getting at least the original capital back. With this new opportunity it is at least technically possible for me to get the capital back – there are no structural or legal barriers, it’s just a question of risk. So I cannot categorize this as a grant situation by my one bright line rule.

From a tax perspective there aren’t many differences to my portfolio between making a grant and writing off an investment. If it’s a grant, I can control the year in which I take the write-off, with an investment I have less control. If it’s a grant then it’s part of my total granting for the year which is subject to a maximum % of my Adjusted Gross Income (although there are few years that I’m close to that), if it’s an investment loss I don’t think there’s an AGI limitation.

What is becoming clear to me as I think about this investment is that, when it’s an investment, I am more invested. I inquire more deeply about the capacity of the organization to fulfill the mission, and I will certainly be doing better followup – at a minimum I need to figure out when I get to write it off. In the ideal situation (which I think is actually rare) I’m monitoring performance and able to add help along the way. Perhaps this means I’ve been a second-rate grantmaker to-date, and this is why grantmakers have begun using investment language: to distinguish what they do as including these sorts of practices standard in their grantmaking. If I were to make this investment as a donation it would be much easier for me to walk away shortly after writing the check. All I need is the receipt.

As a board member I’m always interested in what best practices are. We’ve had some discussions on one board that has two issues in my mind: one, how much we should keep in reserves to balance prudent management with not seeming too flush for more funding; two, being thoughtful about balancing perceived high overhead expenses with good investment in capacity.

I was in a funder meeting yesterday and the speaker made a reference to less than 30% of nonprofits meeting a standard of 6 months expenses in operating reserve. She referenced the Nonprofit Finance Fund as the source of that standard but what I actually see is the stat that 31% did not have 3 months of expenses. So I take it that a nonprofit should have at least 3 months in reserves, and that someone from Grantmakers For Effective Organizations has it in her head that 6 months is a good idea.